An extremist, not a fanatic

October 28, 2011

The bosses' pay con-trick

The bosses’ pay con-trick is getting worse. The pay of average FTSE 100 directors rose 49% last year, with the average CEO getting £3.86m.

I say this is a con for several reasons.

1. The link between pay and firm performance is asymmetric (pdf). In good times, bosses’ pay rises a lot, but in bad times, it doesn’t fall so far. In fact, the biggest influence on bosses’ pay is not so much company performance as simply the size of the firm.

2. Big bonuses and performance-related pay are not technically necessary to elicit performance. There’s plenty of evidence that bonuses are sometimes ineffective at improving effort, sometimesactually counter-productive, and sometimes inferior to fines .

3. The claim that bosses must be paid a lot because their pay is set in a global market is silly. CEOs are paid more in the US than UK, and yet few Brits have become CEOs of US firms; one of the very few exceptions was Martin Sullivan who was CEO of, ahem, AIG. Holding down UK bosses’ pay is unlikely to lead to a mass emigration.

4. It’s not even clear that the average boss has much effect upon corporate performance. Take three facts:

- We know from football that changing coaches has no effect upon team performance. If bosses of organizations as small as 11 men can’t turn around performance, what hope do they have for larger organizations? As Warren Buffett said, when a boss with a good reputation takes over a business with a bad one, it is the business that keeps its reputation.

- Jonathan Haskel and colleagues have found that 80-90% of total factor productivity growth (pdf) comes from plants exiting and entering the industry, rather than from internal productivity growth. This suggests that bosses do less than widely thought to improve organizations’ efficiency.

- The death rate of companies is not only high, but statistically distributed (pdf) in a similar way to that of the extinction of species. This suggests that bosses can no more foresee (pdf) or prevent the demise of their firms than species can foresee or prevent their own extinction. Which suggests that bosses know less than we suppose.

In saying all this, I’m not taking a Marxist view. It was, remember, Hayek who told us that central management was flawed because of the impossibility of aggregating dispersed data.

5. The idea that bosses matter, and must be paid accordingly, plays upon our cognitive biases, such as:

- Fundamental attribution error. We assume that individual must be responsible for outcomes, and downplay the role of environmental or situational factors. So if a firm does well, we attribute its success to management rather than a lack of competition or macroeeconomic forces or just luck.

- Outcome bias. We believe that if something happened, it was inevitable. When a company succeeds, therefore, we look for causes - and the fundamental attribution error directs us to management. We forget that success might be due to luck, or to factors outside management’s control.

- Salience effects. I’ll concede that a handful of managers - Steve Jobs, Jack Welch, Arsene Wenger - can achieve great things. But these are exceptions. Looking at them and inferring that the average manager has great powers is like looking at Kate Moss and inferring that obesity doesn’t exist.

Given all this, you might wonder what the real reason is for bosses’ high pay. Simple. Power. Bosses , generally, might not have the power to create super-efficient high-performing firms, but they do have the power to extract rents from shareholders and workers. Like some City traders, they must, in effect, be bribed not to plunder the firm’s assets. From the point of view of shareholders, the small theft that is a multi-million pay-packet is better than the large theft of wilful mismanagement.

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"We know from football that changing coaches has no effect upon team performance. If bosses of organizations as small as 11 men can’t turn around performance, what hope do they have for larger organizations? As Warren Buffett said, when a boss with a good reputation takes over a business with a bad one, it is the business that keeps its reputation."

This is true for some businesses, but not for all of them. I would guess that stable, mature firms which operate in slow-moving markets can't be improved much, and any attempts to improve their performance beyond their natural limits is likely to be counter-productive (banks, insurers, oil companies, etc.). But technology firms can undergo great swings which do seem to correlate with particular corporate leadership - Steve Jobs is everyone's favourite example, but he's not the only one by any means. Lou Gerstner's turnaround of IBM in the early 90s is a positive example; Microsoft post-Bill Gates is a negative one. Buffett is famously much better at investing in the kind of slow-moving businesses where management can't change the fundamentals than he is in investing in innovative or fast-moving companies, which gives him a fairly substantial bias.

The question is, how can we tell the difference between a boss who is genuinely affecting outcomes and one who is simply taking credit/avoiding blame for the firm's performance? My guess is that mature firms should be fairly easy to identify, and that these firms should move towards a more consultative (democratic?) management style that emphasises doing existing things well rather than the relentless 'change' that every wannabe CEO would advocate for its own sake. But this is still a world away from the kind of management at, say, Amazon (if you have 10 minutes, the link is worth a read), which has to emphasise central control in order to get things done, and the corporate bottom line is substantially dependent on one person at the top making the right decisions over a period of years.

Are investors capable of telling the difference between the two scenarios, and would they demand the correct type of management?

I've long suspected the exorbitant remuneration packages given many CEO's are self-defeating and against the interests of the companies concerned. Reward should induce effort and this is best achieved when remuneration is set at a sufficiently modest level to ensure the future interests of the company are always the priority.
As it is, appoint the guy (or lady)and he's effectively already made it! The monetary “carrot” is lacking.

So really what you are saying here is not a social justice point but that the shareholder model is inefficient in a number of respects. Actual pay for "top people" is a social status construct. It reflects custom and the idea that people like us deserve high material rewards. As people "like us" are the ones setting pay so we naturally give high pay to our kind of people. The firms actual legal owners could pay a lot less with no lose in their economic interests but cannot be bothered to challenge the status assumptions underlying the custom. Seen more broadly this is both a social and economic problem, the excess rent of the boss has no utility for firm or society and is an unjust income which presumably is a diversion from pay for more productive employees lower down who have less power or status but who are more responsible for the firms success or failure. Which is what every trade unionist knows to be true anyway! You could also point out that there is a strong tendency for firms which have been successful to waste their capital on new ventures and products from ego bias and overconfidence. Bringing about their decline and eventual bankruptcy. Which also shows the limitation of the firm structure.

"The bosses pay con trick" - A plea for responsible commentary and reporting.

There are 4.5m+ UK businesses employing 22.5m. SMEs account for 99.1% of all enterprises & 59.1% of private sector jobs. Most are owner operator directors with their life savings on the line and their homes underwriting their businesses.

FTSE directors are normally employees of their shareholders. They have parachute protections at every turn. Their pay and benefits are a complete anachronism to 99.9999% of company directors.

When people gob off about company directors, please caveat that you are only talking about 0.0001% of all company directors.